Should You Really Buy Upstart Stock Now?

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One of the biggest market losers in 2022 is Assets received (UPST 1.41%). Its stock price is down nearly 85% year-to-date and it appears investors have dumped the stock, assuming its business model is broken.

But as we’ll see, there’s good reason to believe the business model still works. And if it works, Upstart stock could be a market-beating investment from here.

Why Investors Abandoned Upstart

From its initial public offering (IPO) price of $20 per share to its peak in mid-2021, Upstart stock has grown 19.5 times its value in less than a year as a public company. Now, almost exactly a year later, it’s down about 94% from that peak. Clearly, something happened to make investors abandon Upstart shares.

To understand what happened, we first need to look at Upstart’s business model. The company connects lenders with borrowers, trying to help both parties. Borrowers want lower interest rates. Lenders want to be repaid. Upstart uses artificial intelligence (AI) software to instantly measure credit risk based on more than 1,500 factors, theoretically leading to fewer defaults for lenders and better interest rates for lenders. borrowers.

Upstart makes these loans possible. But it’s not about holding the loans; the company’s banking partners do not always hold them either. The business model relies heavily on institutional investors. And that party’s loan funding has recently dried up. With less institutional money to fund loans, Upstart was unable to process as many as it would have liked, resulting in lower revenues.

The timing of this issue coincides with the Federal Reserve raising interest rates, as shown in the chart below.

Effective federal funds rate data from YCharts.

In the first half of 2022, Upstart actually closed the aforementioned funding gap with its own balance sheet, a move investors didn’t like because of the fundamental difference between servicing loans and processing loans with software. At the end of the second quarter, the company had $624 million in loans on the balance sheet.

Investors do not know if this situation for Upstart is permanent or temporary. Some believe institutional investors are shunning Upstart loans because default rates are rising and rising interest rates are giving those investors comparable returns elsewhere with less risk. If this is true, then Upstart may be forced to continue using its own resources in future quarters to fund loans, which would not be good for shareholder returns.

Why Upstart Stocks May Be a Buy (For Some)

There are two reasons why the market can blow this whole situation out of proportion. First, the recent increase in default rates might not be a big deal. Consider that default rates fell early in the pandemic when there was an abundance of economic stimulus money. Now that there are none, default rates are increasing for Upstart. As a result, some investors question Upstart’s AI performance capabilities under all economic conditions.

However, the whole industry lives the same reality. For instance, loan club recently noted that its delinquency rates were “normalizing” — in other words, increasing from extraordinarily low delinquencies in 2020 and 2021. Additionally, American Express and Discover financial services both have recently noted an increase in net imputations. Therefore, this is clearly an industry issue, which means it’s unfair to criticize Upstart’s AI efficiency based solely on its recent defect rates.

Second, the market assumes that institutional investors are turning away from Upstart lending, but that’s not necessarily the case. In times of uncertainty, people will put their investing activities on hold pending greater clarity. Consider that bonds are in a bear market. The decline in bonds is a historical anomaly and suggests a reluctance among institutional investors to be active in this space as well.

Chart ^MOUSBMYO

^MOUSBMYO data by YCharts.

Institutional investors may simply pause their investments in loans issued by Upstart, waiting to see when inflation and interest rates peak to better make informed long-term investment decisions. That’s what Upstart management thinks. Therefore, it is entirely possible that we are again looking at a macro issue, and not an Upstart issue.

Assuming both of these things are true, then at worst, Upstart’s business model is simply prone to cyclicality – it’s not a flawed business model. It’s a big difference. Investing in cyclical stocks is not for everyone. But for those willing to weather that risk, Upstart shares could offer tremendous value right now.

Upstart shares are currently trading at less than twice sales, its cheapest valuation ever. And it can potentially increase sales exponentially for years to come. Consider that it keeps gaining new banking partners and credit unions. It is diversifying into loan categories like auto and mortgage, which are much larger than its core personal loan market. And institutional investors could return to loan funding in time.

All of these things could kick-start Upstart’s growth and unlock above-market returns for those who buy today.

Discover Financial Services is an advertising partner of The Ascent, a Motley Fool company. American Express is an advertising partner of The Ascent, a Motley Fool company. Jon Quast holds positions at Upstart Holdings, Inc. The Motley Fool holds positions and recommends Upstart Holdings, Inc. The Motley Fool recommends Discover Financial Services. The Motley Fool has a disclosure policy.

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